John Mauldin on China.

"The basket is likely to be heavily dominated by the USD. Using China's trade weights, normalized, a five currency basket would have the following weights: USD (27%), JPY [Japan](31%), HKD (Hong Kong] (24%), EUR (15%), and GBP [Great Britain](4%). The hard dollar pegs (USD and HKD) account for close to 50% of the basket. If you consider the JPY as a soft USD peg, the weight on the dollar could be as high as 80%. This means USD/RMB will still be very 'docile', with the index being 'sticky' relative to the USD." (Morgan Stanley)

Right now we don't know what the basket will actually look like. It is doubtful that China will announce the make-up of the basket. Clever currency traders will soon be running a regression analysis that will give us a reasonable idea. Of course, it will be very risky to trade on that, because the Chinese could change the makeup of the basket at any time. My bet is they will do so from time to time just to cause a lot of pain to hedge funds so as to discourage speculation.

What those clever Chinese have really done is take some of the wind out of the sails of the protectionist camp. This new currency regime is essentially the same as that of Singapore. You don't see anyone in the protectionist camp ranting about the unfair currency manipulation of Singapore. The Chinese will be able to, quite correctly, point out that if we have no problems with Singapore then we should therefore have no problems with them.

In practice, what I think the Chinese will do is to slowly allow the yuan to appreciate. By slowly, I mean 2-3-4-5 years and by 5-10-15%. This is going to be like watching paint dry. It will not be the stuff that great speculations are made of. And since local Asian currencies are really pegging themselves to the Chinese yuan, it will mean slower appreciation in most of those currencies as well.

"The issue of surplus capacity has become very worrying for policy makers in Beijing also, because there is no pricing power and, therefore, there will be an impact on the financial sector. Every company will need a piece of the same pie. Prices will fall even more. Companies will need more loans to survive and so on. The deflation story, so frightening to Greenspan, will grow into a live problem in China. Even with rising demand, prices continue to fall because of this chronic surplus capacity. There is a risk of a large knock-on impact on the financial sector, less on the big banks, but more focused on the local and regional banks and money co-operatives, of which there are about 120 of the former and 30,000 of the latter category.


1. Businesses that only focus on creating capacity without regard to profitability will not receive local government support

2. The new focus must be on return on capital investment

3. Businesses must go up the value added scale. This means introducing new technology, more expenditure on R&D, taking out more patents etc., and

4. You are encouraged to go further inland if you want to expand. Funding for expansion in Ningbo is now very tight and land licenses difficult and expensive to obtain.

"The last point is very important. It is the cornerstone of new government policy, which will be seen when the new 5-Year Plan is brought out either late this year or early in 2006.

"Urbanization of coastal cities will be slowed sharply. Costs have become too expensive and how to manage the migration of workers is a difficult issue. Instead, new development of industry will be encouraged to go into the rural sectors, where transport systems have improved, where land costs are a fraction of that in the coastal cities and where wages are one-third or less."


So, is the whole world all going to be buying Chinese goods? Should we just pack it all in? In a word, no. "Moreover, China is no longer being considered the first choice for new investment by manufacturing companies in Taiwan or S Korea; the first choice is now being given to other countries in Asia, such as India, Vietnam and now Malaysia....For instance, only on Friday, Flextronics, the world's leading contract electronics maker, announced that it would expand its Malaysian manufacturing facilities to counter rising costs in China. Peter Tan, the company's Asian President, said 'Its pretty clear that in China there is only one way that costs will go, and that is up, given the fact that China is so dependent on the rest of the world for its energy needs...There are a lot of odds being stacked up against our existing presence in China'."

At some point we are told, foreigners will get tired to buying US assets. And I agree, that is true. But it could be a lot longer than most of those with a bearish mindset think. We have $44 trillion (or so) in assets in the US. This total asset base grows every year by several times more than the trade deficit. So while the trade deficit as a percentage of GDP is staggeringly high, as a percentage of assets it is modest.

This game will go on as long as Asia decides to take our dollars. It is pretty much that simple. There are simply too many dollars and yen and yuan and baht and pesos and euro, and too few opportunities. That money has to find a home. And, for better or worse, the current home of choice is the US.

The hope of each of these governments and central banks is that if they go slowly enough their own country will build its own consumer engine and they can wean themselves off their dependency upon the US consumer who pays in electronic dollars. They hope to grow their own economies to the point that investment dollars stay in their own country rather than looking for safety and growth in the US.

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